Carbon Trading: Environmental Godsend or Giant Shell Game?

The lively debate over whether cap-and-trade really does much to fight global warming

By Jennifer Barone|Wednesday, December 03, 2008
reforestation
reforestation
Paso Pacifico's reforestation project in Nicaragua is funded by offsets via Carbonfund.org.

Josh Margolis keeps a grueling schedule, brokering deals between buyers and sellers and forecasting how government actions could affect his clients. But his obsession is not stocks, or bonds, or oil futures. As co-CEO of the San Francisco–based company CantorCO2e, Margolis is part of an exploding branch of finance in a new commodity: carbon.

Mainstream financial institutions including Merrill Lynch, J.P. Morgan, Deutsche Bank, and Goldman Sachs are joining the booming carbon market, which continues even through the current economic jitters. According to the World Bank, global trades in this market in 2007 were valued at more than $64 billion, more than doubling since 2006. Skip Willis, president and CEO of Carbon Capital Management, a Toronto-based “carbon monetization” corporation, predicts that by the end of 2008 the global carbon trading system will have topped $100 billion. “This is a market that barely existed five years ago,” Willis says.

The carbon market was born out of the 1997 Kyoto Protocol, which mandates the curbing of carbon emissions. To comply, the 182 nations that signed the protocol must meet targets for reducing emissions of greenhouse gases—climate-warming gases that include the common industrial by-products carbon dioxide and methane. Meanwhile, many companies are participating in carbon trading voluntarily, either to build a green reputation or in anticipation of looming regulation. (DISCOVER recently did its own carbon-offset experiment; see the results on the bottom of the next page.) The United States never signed the Kyoto Protocol, but growing concern in this country over climate change may soon bring some form of regulation here, too. Joseph Romm, who served as acting assistant secretary of energy during the Clinton administration and now edits a climate policy blog as a senior fellow at the Center for American Progress, predicts that “the United States is clearly going to have a carbon trading system in the near future.” He notes that the president-elect supports such a plan.

Behind the carbon wheeling and dealing lies a market mechanism called cap-and-trade. “What a cap-and-trade tries to accomplish is the most cost-effective way to achieve emissions reductions,” says Eric Klein, a senior broker with the New York office of the emissions trading company TFS Green. The government sets a cap limiting the total amount of greenhouse gases that an industry, sector, region, or the country may emit. It then sells or grants permits to businesses covered by the cap. Each permit essentially allows the license holder to release the equivalent of 1 ton of carbon dioxide and can be traded among emitters and financial institutions. “Over the course of the year,” Klein says, “if you emit above and beyond the amount covered by your permits, it’s your responsibility to buy more of them on the open market. If you emit less than your limit, you can sell your extras on the open market.”

Mandatory carbon trading programs, such as the European Union Emissions Trading Scheme (EU ETS) that began in 2005, have their roots in the U.S. Clean Air Act amendments of 1990. That legislation, which Klein calls “the granddaddy of all emissions trading markets,” created a cap-and-trade system for utilities to reduce the sulfur-based pollutants that cause acid rain. “A cap-and-trade system says, ‘You have to reduce overall emissions, but how you do it is your business.’ That flexibility saves a lot of money,” according to Robert Repetto, economist emeritus of the Yale School of Forestry and Environmental Studies and senior fellow at the United Nations Foundation. Ultimately, Repetto says, the Clean Air Act resulted in the reduction of acid rain pollution more quickly than expected, and at much less expense than what traditional regulation would have cost.

Replicating that success is not as straightforward as it sounds. First, carbon emissions are not currently well quantified. The Clean Air Act amendments required power plants to install instruments that record their acid rain–causing emissions and to report the numbers to the Environmental Protection Agency. Yet in Europe’s carbon trading system—a likely model for the United States—businesses are not required to use monitoring instrumentation. They are allowed to determine their carbon emissions by “calculation.” Although third-party auditors check the process, Michael Wara, a Stanford Law School professor and a researcher at the Stanford Program on Energy and Sustainable Development, acknowledges that there is reason for concern when emitters are doing their own carbon accounting. “Enron is always a specter in the background,” he says, referring to the accounting scandals that sank the giant energy-trading company in 2001.

According to Larry Lohmann, a researcher with the U.K.-based nonprofit the Corner House and editor of a book criticizing the carbon trade, “Even here in Europe, we’re nowhere near being in possession of the technology and enforcement we would need to run a respectable cap-and-trade program, which we’re already supposedly running. The margin of error for what’s coming out of the stacks is way too wide to say whether emitters are in compliance with regulations. And when it’s left up to the companies to do the reporting, they have a huge amount of discretion in saying how much they’re emitting.”

The second problem concerns the validity of offsets, a feature of most existing carbon trading systems. “Under a cap-and-trade program,” Margolis says, “offsets are a form of currency to help participants meet the regulations. If you need to emit less carbon, you can change your process, you can change what fuel you use, or you can find a company that you can pay to reduce those tons for you, which is what happens when you buy an offset.” A company that needs to eliminate 1,000 tons of emissions from its ledger might pay for a project that will plant enough trees to absorb that amount of carbon dioxide.

Lohmann points out that to show that an offset project does what it claims—actually reduce emissions—“you have to argue that there will be lower emissions than would have been the case without the project. That type of measurement is just doomed from the start. And people are aware that it can’t be verified, which opens the way to making any claim you want to make. There have been a lot of complaints about so-called carbon cowboys making a lot of money on nonexistent carbon reductions,” Loh­mann adds. “But since the question can’t be decided scientifically, there’s no sheriff.”

Stanford’s Wara and his colleague David Victor recently investigated a group of offsets offered under the Kyoto Protocol’s Clean Development Mechanism (CDM), which can be purchased for compliance with the E.U. trading scheme. “The basic idea of the CDM is that you cut emissions in a place like China in lieu of reducing them in Europe,” Wara says. “So we need to be certain that we’re really cutting in China. Otherwise the whole goal is undermined.” For instance, power from a new Chinese wind farm or hydroelectric plant might displace electricity that would otherwise come from carbon-spewing fossil fuels. If the developers of these projects can show that these renewable energy sources would never have been built without offset money, then the carbon emissions saved by the new plants can be sold as offsets.

In their study, though, Wara and Victor found indications that offset funding is flowing to projects that would probably have been built anyway. “We can show that essentially every major wind and hydro project in China is claiming credit for CDM offsets,” Wara says. “We know that China has been building about 10 gigawatts of hydropower every year for a long time. Last year, suddenly all of that development was claimed as carbon credits. Is it really the case that none of those projects would have been built without offset money? These offsets are being sold to the United States and Europe, and if they’re not real reductions, we have a big problem.”

Another popular type of offset demonstrates a different kind of problem with the carbon market. HFC-23, an industrial greenhouse gas thousands of times more potent than carbon dioxide, is produced as a by-product in the manufacture of refrigerant, and a number of major offset projects capture and destroy HFC-23, doing a huge service to the climate. But Wara discovered that offset sales from destruction of the gas were far more lucrative than the sale of the refrigerant responsible for creating the pollutant in the first place, giving factories a perverse incentive to produce as much waste as possible and then create projects that sell offsets to destroy it.

Both Wara and Lohmann say that a cap-and-trade program that excludes offsets would probably be more effective at reducing emissions. “When you have offsets in a cap-and-trade system,” Wara says, “it’s like not being able to tell counterfeit money from real money.” Lohmann notes that the acid rain program so often cited by carbon market proponents as a success story did not allow offsets.

David Orr, a professor of environmental studies at Oberlin College, agrees that the concept should be viewed with skepticism. “I’m suspicious of offsets,” he says. “The farther away they get, and the more abstract they get, the more difficult it is to know whether you got what you paid for. And you can’t monitor them. It opens up a can of worms.”

The Presidential Climate Action Project, which Orr cofounded and advises, recommends that the United States bring a new, more streamlined approach to the carbon market. Instead of regulating carbon at the many smokestacks where emissions occur, the group recommends regulating by cap-and-trade permits directed “upstream” at the wellheads, mine mouths, and import points where oil, coal, and natural gas enter the economy. Repetto of Yale points out that unlike a market for emissions, which come from countless sources and can be complicated to calculate, “an upstream system is very easy to administer. There are only about 2,000 initial sellers of fossil fuel that you’d need to keep track of, and their sales are already tracked anyway.” However, an upstream cap-and-trade program would be likely to face political resistance because it would bring a sharp increase in operating costs for power plants that emit greenhouse gases. Orr notes that industry would prefer a downstream cap.

As the nation debates possible structures for federal climate change legislation, many states are already moving forward with carbon-cutting plans of their own. The Regional Greenhouse Gas Initiative (RGGI), a mandatory cap-and-trade carbon market encompassing 10 Northeast and mid-Atlantic states, requires electricity producers to reduce carbon dioxide emissions by 10 percent by 2018. The first batch of carbon permits were auctioned off to power companies in late September, and a second auction is scheduled for December. RGGI does allow participants to buy offsets, but it limits the percentage of required cuts that can be met with such purchases.

Similar programs are arising across the United States. The Western Climate Initiative, covering seven states and four Canadian provinces, and the Midwestern Greenhouse Gas Reduction Accord, signed by six states and one province, are both developing cap-and-trade markets. The plans may speed the development of a nationwide program, since companies that do interstate business would probably prefer a single set of operating regulations. Broker Klein points out that many firms now embrace the idea of carbon emission laws but need “clear rules of the game” in order to plan for them.

As for Wara, the shortcomings of current carbon markets are not enough to dissuade him from his belief that laws governing greenhouse gas emissions should be enacted as soon as possible. “We’re going to stumble, and we need to be prepared for that,” he says, “but my criterion is, what can we do now? Even if we don’t get it right the first time, we need to learn by doing. This is the problem of the century.”

Meanwhile, the carbon market keeps whirring, and Margolis keeps brokering—or, as he likes to put it, “making the world a better place, one deal at a time.”


DISCOVER experimented with carbon trading when we calculated our carbon footprint for the May 2008 issue and bought a $4,796 offset from Carbonfund.org to cover it. The small but growing voluntary offset market (operating outside of government programs like the one in Europe and reaching sales of $258 million in 2007) offers to erase emissions from your business, home, travel, or even your whole life. We, like others who have sought to be a little more green, wondered what we got for our money.

Carbonfund.org finances a changing roster of renewable energy, reforestation, and energy efficiency projects, all certified by third-party auditors. When we checked on the impact of our offset, a spokesperson told us our donation had been pooled with others earmarked for reforestation and renewable energy projects, as we had requested, but added, “Unfortunately, it’s not possible to pin it to a specific project.” So we called some of the projects listed on Carbonfund.org’s Web site to find out how they use offset donations. At a reforestation project in Nicaragua, offset money pays for plants and workers. A power company that produces wind energy told us offset funds are used to reduce prices for consumers.

Anja Kollmuss, a staff scientist with the Stockholm Environment Institute and the author of two recent industry reports, says that while problems exist, voluntary offsets “have helped to get some good projects off the ground ?that otherwise would not have existed.” They also help businesses and consumers develop an awareness of their carbon footprints, she adds.

If you would like to get involved with offsets, both Kollmuss and climate blogger Romm recommend projects certified by the Gold Standard Foundation as the most rigorously vetted ones on the voluntary market.

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